What a Labour win could mean for gilts

The following is an extract from our CIO spring update.

With Labour enjoying a large lead in the polls, we believe gilt investors will increasingly pay attention to what the shadow chancellor has to say. Even though we don’t expect much extra detail between now and the election, by the time we get to polling day we expect investors to have much stronger views.

Ask investors today, “What does a Labour Party mean for the UK economy and the UK gilt market?” and you’ll probably get a version of “nothing dramatic… no more spending than the Conservatives”. But we don’t think that view can last.

Instead, we expect investors will increasingly focus on the continued political pressure to push the spending envelope higher as public dissatisfaction with UK public services rises, with the potential for upward pressure on gilt yields as a result.

That’s a lot of bonds

So does that mean whoever wins the next election could have to issue lots of bonds? Yes, but we strongly believe that the main impact of a UK government decision to spend and borrow more will primarily come via expectations for future Bank of England (BoE) rate moves.

Additionally, the maturities at which the government chooses to borrow can have a meaningful impact on the shape of the gilt curve. While the impact of declining pension fund demand for long-dated gilts and index-linked gilts has been given a lot of airtime in recent years, we think it’s worth taking a step back. Neither supply nor demand are static.

As the amount demanded by pension funds declines, the UK Debt Management Office (DMO) is constantly trying to re-assess how much demand remains and adjust issuance to match. That one-two step dance, where demand declines and the DMO reacts, might mean that supply is constantly a bit behind the curve. But we don’t think this would necessarily lead to drama in the gilt market, as long as the DMO acts responsively.

Indeed, we expect the DMO will show enough flexibility to avoid drama, and with a new chief executive – Jessica Pulay – just announced, it has a unique opportunity to convince investors of the same.

Higher but not steeper

As a result, we don’t believe that the potential for large fiscal deficits and correspondingly high gilt issuance necessarily means that relatively higher yields on longer-dated bonds (i.e. steeper yield curves) are particularly likely. Instead, as mentioned above, we believe that the main impact of more spending could come through expectations for policy easing from the BoE being pushed back.

So, as we get closer to the election, while we do expect upward pressure on gilt yields overall as investors form stronger views about what the Labour Party could mean for borrowing levels, we’re not particularly worried about steepening risk.

This will be welcome news for pension schemes, as it means that we believe the window for them to seek to take advantage of elevated bond yields is likely to remain open for a little while longer.

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The above is an extract from our latest CIO spring update.